In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explore capitalization rates – what they are, how they work, and why they matter – with Senior Commercial Economist Xander Snyder in the fourth episode of The REconomy Podcast “Summer School” series.

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Listen to the REconomy Podcast™ Episode 95:

“A lot of this subjectivity comes from different expectations for income growth, which depends in large part on the demand for the space being leased. That is to say, the demand to lease space typically drives the demand to own it. And both of these measures of demand are captured in this cap rate relationship. Income, a measure of demand to lease space after accounting for expenses, and price, a measure of demand to own space.” – Xander Snyder, senior commercial real estate economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 95 of The REconomy Podcast and our fourth session of the Summer School series, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist and Xander Snyder, senior commercial economist at First American. Alright, class is officially in session. Welcome.

Xander Snyder - Hey Odeta. Hey Mark. Ready for commercial round two?

Mark Fleming - Yes, indeed, Xander. Let's dig right in. What's on the commercial syllabus today?

Xander Snyder - Well, on the last episode, we talked about what distinguishes commercial real estate from residential real estate. And, as a quick recap, commercial real estate is typically purchased as a financial asset, rather than a residence, with the goal of benefiting both from price appreciation, that is price going up over time, as well as income generated from the building's rents.

Odeta Kushi - And, as we mentioned on the last episode, it's worth drawing this distinction about income returns since individual homeowners can also benefit from price returns over time, but do not earn rental income while living in their residence. 

Mark Fleming - Although, one could think of the homeowner as paying themselves rent for the shelter benefit they get from living in that home.

Xander Snyder - True, true, but I think that might be for the Master's class. Today's episode, we're going to talk more about this relationship between the two types of returns -- income and price growth -- that investors seek from commercial real estate investments. And, as you'll see, after establishing this relationship between income and price return, we'll be left with a trinity of commercial real estate returns around which all other returns are derived. But you'll have to stay tuned in through the end of the episode to find out why.

Mark Fleming - I'm channeling The Matrix right now. Trinity, from The Matrix? Yes, yes. But first, let's talk about why there should even be any sort of relationship between income and price in the first place. Odeta, let's say that the Mark Corporation has a commercial building that it's thinking about selling. The building generates $10,000 in profit per year, after accounting for expenses. How much might you be willing to pay to purchase that building in order to receive that recurring $10,000 a year of annual income?

Odeta Kushi - Hmm, well, how about for the sake of round numbers, we say an even $100,000 with no selling fees? 

Mark Fleming - That is so out of character for you. Are you sure you don't want to add any significant digits to the right of that decimal?

Odeta Kushi - Don't make me rethink my offer.

Mark Fleming - Okay, okay. $100,000. Round it is. That implies you'd be willing to pay 10 times the annual profit for that building, day one, to benefit from the recurring income over time. But now, what if instead of $10,000 in annual profit, I told you that the building is producing 20, because I'm a miraculously good manager of it. $20,000 a year. Would you still only be willing to pay $100,000 to buy that building? Or could we negotiate this up a little more?

Odeta Kushi - All right, Mark Corporation is driving a hard bargain. So let's say it's the exact same hypothetical building in the exact same hypothetical location and I'm willing to pay 10 times its profit to buy it. That is 10 times 20,000. I guess that means I'd be willing to pay $200,000 for it, which is twice as much as my initial offer.

Mark Fleming - Exactly. Let's find a pen and get you inked on this deal right away. Your willingness to pay twice as much for the building that generates twice as much income demonstrates this built in relationship between income and price, since you're willing to pay more today to get more income later.

Xander Snyder - So this relationship between income and property prices demonstrated here by Mark and Odeta's cut-tooth negotiations, if I may say, is referred to in the commercial real estate world as a capitalization rate or just 'cap rate.' A cap rate ties together both the income and price components of commercial real estate returns in a single metric. And, in the case of the building that Odeta just bought...

Odeta Kushi - Hold on, hold on, hold on. Escrow hasn't closed yet. I'm waiting for Mark Corp to get back to me. 

Mark Fleming - I'm actually busy consulting with my real estate lawyers.

Xander Snyder - Ah, yes, delays in closing are always fun. And, if you listened to our summer school Episode One on the complete guide to home purchasing and closing you'll have a better idea of what that closing process looks like. So, if Odeta might be purchasing a $100,000 building from Mark Corp, generating $10,000 per year, that means she'd be willing to pay 10 times its income on day one to have that recurring income in the future. So her return each year is $10K, the income divided by $100,000, the price, or 10%. That means that this building's cap rate then is 10%. Saying that you're willing to pay 10 times a property's income to purchase it, is analogous to saying that the property has a 10% cap rate. It's just that the cap rate perspective has a slight emphasis on the income yield generated each year.

Mark Fleming - Okay, so we have agreed that the building I'm possibly selling to Odeta would have a 10% cap rate if she pays $100,000 for that $10,000 income it generates. But wait, there's more. What if I were to tell you, Odeta, that this building I have is really great. I mean, it's an awesome building, and next year, the income will be $15,000, instead of $10,000. So, if you're looking for a property with a 10% cap rate, wouldn't that mean you should be willing to pay $150,000 for this building? Ten times next year's income of $15,000, after all, is $150,000.

Odeta Kushi - Well, maybe I'd be willing to pay for some income growth over time, but the future is uncertain. Mark, how do you really know your property will make $5,000 more next year?

Mark Fleming - Details, details. Since that future is always so uncertain, why don't we meet in the middle at $125,000? How does that sound?

Odeta Kushi - I feel like I need to shop around a little bit here. 

Mark Fleming - Ok, fine. But I think it's safe to say that you'd be willing to pay some additional amount in price to acquire an income stream with good growth prospects, right?

Odeta Kushi - That much I certainly agree with. 

Xander Snyder - Ok, well, for the sake of the argument, let's say that you both settle on this midway price of $125,000. That would mean Odeta would be paying 12.5 times the current income of $10,000 to purchase Mark's property, rather than the 10 times implied by her original offer of $100,000. This means that at this higher price of 125,000 Odeta will be receiving an income return or a cap rate of only 8%. That's 10 divided by 125. Rather than the 10% she would get if she could successfully haggle Mark back down to that $100,000.

Mark Fleming - Never. Notice that if Odeta pays more, this property's cap rate would go down. This sometimes feels a bit counterintuitive, since if you're willing to pay more, wouldn't you expect a higher return. But, if income doesn't change, and you have to pay more to acquire that income, than the cap rate goes down since your income return in each year relative to your investment is now lower.

Xander Snyder - Yes, and this would be a great time to grab the handout for this episode, if you have it handy, and turn to the third page for Episode Four. Here you'll see a downward sloping line that shows this relationship between higher cap rates and lower prices. When you think about the difference between a 5% and 6% cap rate, at first, it might not seem like all that much. But, actually, the valuation impact of a one percentage point increase in cap rates is quite substantial. Holding income constant, so that is assuming no income growth, every time that cap rates increased by 25 basis points, or a quarter of a percentage point, that property's price declines by between 4% and 5%. Therefore, a one percentage point increase in a cap rate resulted in about a 20% decline in property price.

Mark Fleming - So, I guess this begs the question, how lucky are you feeling about that future income growth, Odeta?

Odeta Kushi - Well, you know what they say about predictions, they're hard to make, especially when they're about the future. Nevertheless, the prospect of growth is worth something depending on how uncertain it is and how you go about valuing it. As a result, there's often quite a bit of subjectivity involved in agreeing on a price and the implied cap rate for a transaction.

Mark Fleming - And, while we're on the topic of uncertain futures, the prospects of income growth are not the only thing that a buyer might be willing to pay more for. Stability or security of that income could also add a premium to the price and, as a result, you will usually find lower cap rates in larger lower risk buildings that are full and unlikely to see occupancy drop at any point soon. In this case, buyers would be accepting a lower cap rate, that is a lower annual income yield, in exchange for more certain future cash flows. So, Odeta, could I get you back up to that $125,000, if I tell you that the future income at my building is very, very stiff, I mean very stable, and that's worth the premium.

Xander Snyder - Wow, Mark, when it comes to that sales price, it seems like you just can't get enough.

Mark Fleming - No, I'm not gonna go there. I just can't get enough. Nice setup, Xander. And you can see I had to resist and, if you're not familiar listeners, Just Can't Get Enough, is the classic 1981 Depeche Mode song, which we'll be sure to put on The REconomy playlist.

Odeta Kushi - All right, well, good. '80s references aside, maybe stability is worth $25,000 to you, Mark, but only $10,000 to me. So, I'm sorry, I think I'll have to keep looking at other buildings. 

Xander Snyder - Now, it's worth mentioning that this subjectivity, the inability to agree on what future prospects are worth, often results in multiple types of cap rates being used in a single transaction or investment project. For example, the cap rate agreed on by buyer and seller at close, which is usually referred to as the 'going-in' cap rate might be quite different from the 'predicted' or 'stabilized' cap rate that the building reaches when an investment thesis has been successfully executed. 

Mark Fleming - And, while I clearly disagree with Odeta's investment thesis here, having lost the ability to sell the building. At this point, you might be wondering what we mean by the trinity of returns. Since we've been talking primarily about only two things -- income and prices. Well, time to refer back to that handout for this episode. Typically, cap rates are defined formally as a fraction -- income divided by price, which can seem a bit dry at first, unless you're mathematical like us. Because it is. This typical equation is shown on page three of the handout. But superimposed on top of that equation is a triangle, a trinity, connecting all three parts of this equation, which if you're more visually inclined, shows the relationship a bit more clearly between the three, not just some math.

Xander Snyder - Right, and if you don't have that handout in front of you, just imagine a line with two points. One point is the purchase price and the other is income. Now, while you can draw the single line between those two points, you can't form a triangle without a third point that establishes a clear relationship between the other two points. This third point is the cap rate.

Mark Fleming - And, if you're not an equation person, just remember the trinity of commercial property returns. A cap rate is the relationship between a property's income and its price. And it can be used in various situations to tell you something slightly different about a commercial property that you're evaluating.

Odeta Kushi - So, as we draw towards the end of this lesson, let's take a step back to the conceptual level. At first glance, a cap rate might seem like a pretty simple relationship between two types of returns on a commercial property investment. But, once you start adding all of these uncertainties about future expectations, this relationship becomes more dynamic and subjective.

Xander Snyder - That's right. And a lot of this subjectivity comes from different expectations for income growth, which depends in large part on the demand for the space being leased. That is to say the demand to lease space typically drives the demand to own it. And both of these measures of demand are captured in this cap rate relationship. Income, a measure of demand to lease space after accounting for expenses, and price, a measure of demand to own space.

Mark Fleming - That's a great point. And there is one last thing worth mentioning. Cap rates aren't the only measure of return regularly used in the commercial real estate world. Things like return on equity, multiple on invested capital, and internal rate of return, while out of scope of this lesson -- Master's class, maybe -- are all types of returns that are earned by equity investors in a property, that is people putting their own money up, rather than borrowing it. However, commercial properties are almost always purchased with mortgages. And all of those measures of equity returns are impacted by how big that mortgage is and what its interest interest rate is. A cap rate is a measure of return before accounting for the debt that you might use to purchase that property, which is why it's also sometimes referred to as a measure of unleveraged return, where leverage here is just a fancy word for saying having a mortgage. That's right.

Xander Snyder - That's right. Conceptually, a cap rate is more a measure of the income a building generates, rather than the specific returns earned by some investor. Save for the unusual circumstance when an investor would buy a commercial property outright all cash without a mortgage.

Odeta Kushi - All right, well, that's it for today's episode, I did not buy a building from Mark Corp. But, maybe next time, if you can be a little bit more fair in your negotiation tactics, Mark. 

Mark Fleming - We're not done yet. 

Odeta Kushi - We're not done yet. And thank you, Xander, for joining us on The REconomy Summer School series. Listeners, be sure to tune in next time, where we'll be cracking the code of house prices and affordability. In the meantime, if you have an economics-related question you'd like us to feature, you can email us at economics@firstam.com. And, as always, if you can't wait for the next summer school episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark and @XanderSnyderX for Xander. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.